Sponsored briefing: The Impact of Covid-19

EBN & Co’s Viva Gayer and Jonathan Achiron on the impact coronavirus has had on the M&A sector and what the future may hold for such transactions

The Covid-19 pandemic will continue to affect the world economy. Covid-19 has put nearly every aspect of business operation to a test. We have seen a slow-down in the number and scope of M&A transactions in the first and second quarters of 2020. Whereas 2019 was phenomenal for the Israeli M&A market, it is clear that 2020 and even 2021 will be challenging. The M&A market will need to re-invent itself.

Strategic acquirers have less appetite for growth acquisitions and expansion into new markets and are more focused on maintaining current market share and profitability. Therefore, it is to be expected that strategic acquirers will be less dominant in the near future and high-range acquisitions such as Intel’s of Mobileye will become less frequent. As private equity firms have a limited window in which to utilise their committed funds and acquire target companies, it is to be expected that they will continue to ‘feed’ the M&A market. A dramatic rise in bankruptcies with a concurrent increase in distressed M&A activity is expected as a result of the economic turmoil. For many strategic purchasers and private equity firms with relatively strong cash positions, the wave of insolvency auctions will present significant opportunities to acquire valuable assets at discounted prices.

The decrease in M&A transactions indicates that we are in a pro-buyer market. In recent years, cross-border M&As have turned to pro-seller ‘lock-box’ price methodology (where purchase price is based on the target business’ financial statements at a specific date before signing of the purchase agreement). Since use of ‘lock-boxes’ is not all that common in Israel, Israeli cross-border M&As will probably use more traditional post-closing purchase price adjustment mechanisms (‘completion accounts’), wherein the purchase price is adjusted (‘trued-up’) to the state of the business at closing.

One of the challenges that the M&A market now faces is how to evaluate target companies. Traditionally, last 12 month (LTM) financial metrics are used to determine a target company’s valuation and are the basis for the agreed purchase price. Although short, a 12-month period is useful because it indicates a company’s most recent performance and reveals the company’s current financial state. It seems that post-coronavirus this method is no longer sufficient, since it disregards the impact of Covid-19 on a business and the overall market in which the target company operates. Therefore, it should not be employed to predict the business outlook in the years post-closing. One of the ways to mitigate the complexity of determining company valuation is to introduce more nuanced price adjustment mechanisms and payment structures like earn-outs and other conditional payment structures. These structures entitle sellers to receive the full purchase price only if the business going forwards meets certain benchmarks. This splits the risk of low performance post-closing between sellers and acquirers and protects the acquirer from overpaying for an over-valued asset. We envision that until the global effect of the Covid-19 pandemic on markets is fully understood, more M&A transactions will include these conditional apparat uses.

M&A transactions are financed both through purchasers’ own resources and debt financing. Financial institutions will be more reluctant to participate in high-risk transactions and therefore it is expected that the financing of these type of transactions will be prolonged and in certain very high-risk markets may not even be provided. This will have a negative impact on the transaction cycle, including extending it by several months. There will be a direct impact not only on the number of the transactions concluded but also on the dollar-value of such transactions. We note that the exponential growth of unicorn companies (ie, companies with over $1bn in valuations) in recent years is expected to decrease.

Investment in early-stage companies by venture capital funds continues to flourish, especially in the arenas of cyber security, artificial intelligence and deep learning. This is an indication that when M&A markets revive and return to their 2019 level, many opportunities will present themselves and Israel will continue to be a vibrant market for M&As.

Conclusion

World finance will need to accommodate to the Covid-19 pandemic. We can already see an increase in the number of transactions finalised during the second and third quarters of 2020. In light of the nearly universal adoption of digital technology across all industries and sectors it is not surprising that high-tech will be the sector exhibiting the highest durability in the Covid-19 era. This trend will likely continue into 2021. As the premier start-up nation, there is hope for optimism in the M&A market in Israel.